Oil and bond yields signal shift from deflation worry

Europe's deflation scare is over - inflation is back. That is one interpretation, at least, of a tumultuous week in the region's bond and other financial markets.

So far in 2015 the story of continental Europe has been about central bank action to avert a damaging deflationary slump, triggered by sharp falls in global oil prices. This week, however, two things changed, triggering a shock wave across markets and highlighting the risk of investor complacency.

First, oil prices rose to their highest this year. Second, benchmark 10-year German Bund yields - which supposedly signal investors' inflation and economic growth expectations - experienced a bout of exceptional volatility. Having fallen to just 0.05 per cent in mid-April, they shot as high as 0.78 per cent, before easing again.

Disentangling the extraordinary moves has baffled even seasoned market professionals; German Bunds should be dull and stable. Large-scale European Central Bank "quantitative easing" purchases have distorted the signalling role of bond yields and much of the sell-off was about profit-taking and investors exiting crowded positions. But evidence is growing of a decisive change in market expectations about future inflation.

"My feeling is that there has been a shift away from deflation worries - the 'deflation trade,' which led to the collapse of long-term yields - towards some kind of reflation story," says Frederik Ducrozet, economist at Credit Agricole. "So it's no surprise that at least the fast money has shifted out of Bunds."

Trevor Greetham, senior manager at Royal London Asset Management, adds: "There is likely to be a global headline inflation shock in the second half of this year - although it will be one of the most predicable shocks ever."

If perceptions have really shifted, bond markets may have reached a turning point, with European yields unlikely falling to fresh lows and possibly on a trend rise. With the US Federal Reserve expected to raise US interest rates later this year, that could ignite much more volatility across global bond markets - if not worse.

This week's upsets ricocheted across Europe's markets. The euro rose while share prices dropped - perhaps counterintuitively, because an escape from deflation should help corporate earnings.

"Equities hate deflation so if bond markets are moving away from [pricing in] deflation that should be constructive but the speed of the move has been a problem," explains Nick Nelson, European equity strategist at UBS. Eurozone shares ended the week down 4 per cent from their April 15 peak.

The inflation outlook will hang crucially on whether evidence mounts of a pickup in economic growth - and what happens to oil prices. Since falling by 60 per cent between June and January to a six-year low of $45 a barrel, crude oil has posted a strong recovery. On Wednesday North Sea Brent, which prices around two-thirds of global crude deals, hit a high for the year of $69.63 a barrel, its rally fuelled by stronger demand and a near record number of hedge fund bets that the US shale boom would slow.

A linear rise to $100 a barrel by the end of the year would theoretically push annual eurozone inflation from zero per cent in April to 1.8 per cent in December, according to calculations by UniCredit. With inflation back within the ECB's target of an annual rate "below but close" to 2 per cent, the future of its QE programme would be thrown into doubt.

Such scenarios could, however, quickly prove wrong - if the stronger euro or higher oil prices hit growth, for instance. Moreover many investors are asking if oil's rally is sustainable. By Friday Brent had already fallen back to nearer $65 a barrel as traders said the recovery had come too soon. US shale operators say the price rally may allow them to keep increasing output, adding more oil to an oversupplied market.

"You are hearing one US exploration and production company after another saying they are going to deploy more rigs in the second half of the year than the first," says Edward Morse, head of commodity research at Citigroup. "You also can get as much as another 700,000 barrels per day incremental growth in 2016 from the backlog of drilled-but-uncompleted wells in 'shale plays'."

So far the change in market inflation expectations has not been dramatic. "It doesn't feel like a strong end-of-cycle pick up in inflation" says Mr Greetham. The swaps markets assume an average eurozone inflation rate over five years starting in five years of 1.8 per cent - up from less than 1.5 per cent in January, but still significantly lower than in recent years.

"Markets are still pricing in extremely low levels of inflation - and nobody is forecasting much of an acceleration," says Laurence Mutkin, global head of rates strategy at BNP Paribas. "I don't think you can expect annual rates to rise soon above 2.5 per cent on either side of the Atlantic, so you don't have to see bond yields rising much further either."

Nevertheless, the change in sentiment is noteworthy compared with past gloom. Gilles Moec, European economist at Bank of America Merrill Lynch, warns: "The market is waking up a bit late to the fact that global deflation is not going to happen."

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